Just like mergers and acquisitions, modeling for leveraged buyouts (LBOs) also requires special skill and knowledge. In this article, we will have a closer look at how leveraged buyouts work as well as how financial modeling techniques need to be adopted to meet the needs of investors indulging in LBO’s.
What is a Leveraged Buyout?
A leveraged buyout is a special type of acquisition. As the name suggests, this type of acquisition involves the extensive use of leverage i.e., debt. Hence, if a company takes over another company using large amounts of debt to fund the process, then the transaction is called leveraged buyout. There is no standard definition of how much debt constitutes a leveraged buyout. However, if more than 50% of the purchase price is funded using debt, then the acquisition is generally referred to as a leveraged buyout.
Over the past years, leveraged buyouts have polarized the investment community. There are some people in the industry who swear by the usefulness of leveraged buyouts. On the other hand, there are other people who believe that leveraged buyouts benefit nobody except the people financing them. This is because leveraged buyouts are like a high stakes gamble wherein the company obligates itself to making large debt payments over several years. If they are able to increase their cash flows in order to pay back the loans, then all works out well. Otherwise, even established companies end up in bankruptcy because they lose large amounts of equity value to debt payments.
How Leveraged Buyouts Create Value?
A financial modeler must have a clear understanding of how leveraged buyouts create value. This understanding is important because it is the financial modeler’s job to highlight the value drivers in the model clearly. The decision-makers should not have to spend much time understanding how the proposed value will be created. Instead, the model should be intuitive and easy to understand. Usually, LBO’s are known to create value in one of the two ways mentioned below.
- Increase in Enterprise Value: Leveraged Buyouts involve the use of large amounts of borrowed funds to increase manufacturing capacity. One way of creating value is by increasing the share of the pie i.e., the revenues. The trickle-down effect would mean that the value to equity shareholders will also increase rapidly.
- Debt Reduction: On the other hand, another strategy is deployed when the company operates in a mature industry, and top-line growth is not easy to achieve. In such situations, investors aggressively work to find ways of cost-cutting. Every additional dollar saved during cost-cutting is immediately thrown at debt reduction. When debt gets reduced, the value automatically gets added to the equity shares.
Why is Modelling for Leveraged Buyouts Difficult?
Generally, firms only take on short term and long term debt. Hence, their cash flow is easy to predict. The modeler only needs to multiply the outstanding debt with an interest rate. Later, adjustments are made for new debt raised and existing debt repaid. However, the complexity is low. Hence, modeling is not very difficult.
However, this is not the case with leveraged buyouts. Since firms require a lot of debt, they usually take it from different sources on very different terms and conditions. Hence, predicting cash flow becomes a challenging task. Some of the types of debt commonly used in a leveraged buyout have been explained below.
- Amortizing Debt: Amortizing debt means that the firm pays a part of the principal each month along with interest. These payments are calculated based on the amortization schedule agreed upon between the lender and borrower. Usually, long term loans are amortized. Also, amortized loans have a lower interest rate since the repayments are being made every month, and there is less risk involved.
- Non-Amortizing Debt: Leveraged buyouts involve the use of other kinds of debt. Here, only the interest payments are made on a periodic basis. The principle is returned at the end of the period. This is called non-amortizing debt or debt with bullet repayments. This usually has a shorter term and has a higher interest rate.
- Revolving Debt: While engaging in leveraged buyouts firms also ask financers for revolving debt facility. This facility works like an overdraft. Firms are sanctioned a fixed amount which they can draw down if they want. However, they have to pay interest only on the amount of debt which they have actually undertaken. This becomes a challenge for financial modeler. The financial modeler has to build in a reserve figure in the model. If the cash flow goes below that figure, the firm will replenish it using revolving debt. Then the modelers have to calculate the amount of revolving debt and when the interest and principal will be paid back!
- Convertible Debt: Lastly, leveraged buyouts also involve the use of convertible debt. This means that the debt automatically gets converted into equity if certain conditions are met. The financial modeler has to build in this logic in the model since the cash flow of the firm faces a huge impact when a huge chunk of debt no longer has to be repaid.
It is important to understand that only the types of debt have been mentioned above. For each type of debt, the firm has many tranches, and there are different terms and conditions attached to each tranche. This is what makes financial modeling for leveraged buyouts mind-bogglingly complex.
