LBO Pricing

Background

A leveraged buyout (LBO) is a type of business acquisition in which a buyer (typically a private equity partnership) acquires a company and uses debt to finance a significant percentage of the purchase price.  

 

The proportions of debt and equity capital used to finance LBO transactions depend on a number of factors, including:

 

• Credit market and general economic conditions. 

• The historical and forecasted operating performance and management expertise of the company to be acquired.

• The ability of the acquired company to meet forecasted interest and principal repayment requirements.
• The market value of the tangible assets to be acquired.
• The buyer’s appetite for financial risk.

 

In an LBO transaction, the assets of the acquired company are pledged as collateral for debt, and the acquired company (or a newly formed company containing the assets of the acquired company) is the borrower. The debt is usually in the form of secured bank loans and, if the acquisition is of sufficient size, subordinated debt provided by investment partnerships.

 

LBO debt is almost always non-recourse to the business buyer, meaning the buyer is not liable if the debt is not repaid by the borrower. If the borrower defaults on the debt, the lender(s) may seize the pledged collateral, and debt recovery is limited to the amount realized from the disposal of the collateral.

 

The LBO form of business acquisition is attractive to business buyers because they need to fund only a fraction of the acquisition purchase price. This funding strategy reduces the buyer’s at-risk equity investment, and enhances his return on investment, if the acquired company performs as expected.  

 

If the acquired company does not perform as expected, the debt service requirements of a leveraged capital structure can range from very challenging, to a situation in which the buyer’s equity investment is worthless.

 

LBO Pricing

LBO pricing uses the financial structure and analyses techniques employed by LBO buyers to estimate the value a business. The valuation presumes the business buyer is a “financial buyer” (for example, a private equity partnership) that owns no other company in the acquired company’s industry and, therefore, expects all of its investment return to result solely from the forecasted performance of the acquired company.    

 

An LBO valuation is typically built on a five-year financial forecast of the acquired company’s operations. The valuation analysis forecasts the operations of acquired company during the forecast period, the debt and other liabilities repaid during the ownership period and contains an assumption about the multiple of earnings a business will be sold for at the end of the ownership period. By targeting pre-tax annual rates of returns on equity and subordinated debt investments consistent with those sought by private investment funds, an LBO valuation estimates the purchase price a financial buyer should be willing to pay for a business to achieve those returns.  

 

In general, an LBO valuation estimates the minimum current value of a business since buyers who already own similar businesses and would benefit from operational synergies with the acquired company, will usually pay more for a given business than will a financial buyer. These synergistic buyers are also known as "industry buyers".  

 

An LBO valuation model can emulate industrial buyer pricing by adjusting the financial forecast of the acquired company to fit its revised ownership - generally by increasing forecasted sales and/or reducing costs and expenses of the acquired company due to its ownership by a complementary enterprise.