The LBO (Leveraged Buy Out) guide

Introduction

Whether you are interested in private equity, investment banking, M&A or other financial advisory services (such as Transaction Services, Valuation or Restructuring), it’s important to be familiar with Leveraged Buyouts (LBOs).

This is a crucial aspect of corporate finance, and in this article, we will explore its definition and implementation. We’ll also discuss the characteristics of a good LBO target, the benefits of this financial structure, and provide examples of both successful and unsuccessful LBOs that have contributed to tarnishing the reputation of this structuration.

Definition and functioning of the LBO

The LBO, or Leveraged Buy Out, is a financial structure that enables the acquisition of a company through the use of a significant amount of debt. The acquisition is financed by a combination of debt and equity, with private equity funds typically contributing the equity component and banks providing the debt. Due to the large amount of debt involved, not all companies are suitable candidates for an LBO.

The target company for an LBO must have certain key attributes, including:

Strong operating profitability reflected by a solid EBITDA
A steady and predictable free cash flow
Low or manageable levels of debt prior to the transaction
Skilled and experienced management

To secure the loan, banks:

Assess the financial stability of the target company
Evaluate the predictability of its cash flows over the repayment period
Impose strict covenants to control the target company’s management throughout the duration of the LBO
Often use the target’s assets as collateral to secure the loan.

How is the LBO structured?

The LBO implementation involves the creation of a holding company. Investors form this acquisition holding company, known as NewCo or HoldCo, to acquire the target company with the use of leverage. The holding company is owned by investors and historical shareholders. This holding company will take on significant debt to allow the investors to limit their equity contribution. This is how they can benefit from the famous leverage effect.

Then the NewCo purchases 100% of the target company, referred to as OpCo. The debt provided by banks is repaid to the lenders through the profits generated by the OpCo and partially paid back to the NewCo through a dividend payment.

Let’s examine the role of each player in a typical scenario:

The seller of the target company (OpCo) wants to sell it.
The OpCo managers are interested in buying the company but do not have enough money to do so on their own.
So, they approach Private Equity funds to make up the equity contribution. After a lengthy analysis, the PE fund(s) agree(s) to contribute 30% to 40% of the financing.
Banks and debt funds act as lenders and complete the financing to make the “leverage effect” possible.
A holding company is created for the acquisition, and this company takes on debt to acquire 100% of the target.
The holding company repays the loan through a dividend payment from the OpCo.

What is the interest of the LBO arrangement?

A typical question in corporate finance interviews.

The interest of the LBO arrangement can be described as follows:

Acquisition of the target company: The LBO structure enables investors to purchase the target company despite limited equity capital, as the financing is primarily obtained through debt.
Profitability optimization: Investors can maximize the return on their equity capital by taking advantage of the leverage effect. It is important to note that the economic profitability must be higher than the interest rate of the debt, otherwise the debt will negatively impact the company’s financial performance.
Tax optimization: The integration regime used in LBOs allows for a tax shield. The target company’s payments to the holding company are recognized as dividends and enable corporate taxes to be paid only once at the group level. Additionally, the interest on the debt is tax-deductible.

Note that many studies and researches have been conducted on the reason of value creation during an LBO. The most important factor is not the bank leverage or even the tax shield but it is simply the increase in EBITDA. Here is an article from Capital Finance on the subject for those who want to dig into this point.

Some studies and interviews reveal that the managers are incentivized to operate the company in the most efficient and profitable manner, as the debt repayments and covenants have to be met, and the private equity funds have a say in the company’s management through board representation. This can lead to an improvement in the company’s operations, leading to a rise in EBITDA and overall financial performance.

Where does the negative perception of LBOs come from?

Despite these value creation levers, LBOs do not always have an excellent reputation.

The negative perception of LBOs stems from a period in the 1980s when finance was less regulated and the debt component in total financing could reach up to 90% with high interest rates. This resulted in many LBO companies being unable to meet their repayment obligations and ultimately filing for bankruptcy.

The risks of LBO for the company :

A high level of debt can result in high interest rates and a decrease in the credit rating.
Strong pressure on the shoulders of the managers (financial covenants, shareholders who are very vigilant with the reporting, etc.)
In the event of difficulties, obtaining additional financing or quickly improving profitability can be challenging. This may result in cost-cutting plans or layoffs.
Lastly, bankruptcy can occur if the company is unable to repay the loan.

For lenders and investors, the risk is even more apparent. They may not see their money again. LBOs offer banks the opportunity to earn high interest rates and funds to attain high internal rates of return. But as always in finance, high profitability is counterbalanced by a high risk of loss.

The case of Vivarte: a failed LBO

Vivarte is a French ready-to-wear group with brands including La Halle aux vêtements, La Halle aux chaussures, André, Caroll, and Minelli. In 2007, British fund Charterhouse led an LBO for the group, which was valued at €3.46 billion and financed by debt of around €3.4 billion. It is therefore close to a full debt financing.

The transaction was concluded at a high multiple of 9.4 times the 2006 EBITDA. This allowed the former owner of 66.6% of the group’s shares, PAI Partners, to receive a multiple of 5 times its initial investment within just three years.

However, following the transaction, the group experienced a drop in sales that made its debt repayment schedule too difficult to meet. We are starting to see signs of a failed operation.

It took three consecutive restructuring efforts (in 2014, 2017, and 2019) to erase the massive debt incurred during the LBO. However, this debt elimination was actually a conversion into capital, meaning that creditors have taken back a significant portion of the company’s capital. The firm has sold off several of its subsidiaries, such as KookaÏ, Pataugas, Naf Naf, and André.

At the end of the third restructuring plan in 2019, the company had only generated €40 million of EBITDA, compared to €360 million in 2006 prior to the LBO (source: PE magazine).

To gain further insight into the Vivarte LBO, here is an article from Le Monde that covers each stage.

Learn more about LBOs

If you’re interested in learning more about LBOs, consider reading this article from Investopedia which presents the genesis of the historical LBO of RJR nabisco by KKR. It is a classic to know.

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Conclusion:

LBO is a form of buyout operation made possible through high levels of bank leverage. However, since the 2008 financial crisis, the conditions for structuring an LBO have shifted with a decrease in the debt ratio and stricter financial covenants. The proper balance of debt is now crucial for the success of this type of operation which can lead to favorable outcomes.