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Leveraged buyouts (LBO’s) are celebrating their 30th anniversary as a widely accepted deal form, so this month I thought it would be informative to look at why they have been so popular.
A good LBO candidate business has stable earnings and cash flow, little debt, and many assets (preferably tangible ones like real estate). With these attributes, the business can support a very high level of debt and requires a low level of equity. In other words, one could buy this business with a small cash (equity) investment and be able to borrow most of the purchase price.
All of the numbers that follow are rough and vary with business and financial conditions. A typical LBO is priced at 7 times EBIT (earnings before interest and tax expenses, the operating profit of the business, which is assumed unaffected by how it is financed; i.e. by the LBO). As much as 80% of the buyout funding is borrowed, with the remaining 20% provided as buyer equity. Debt bears 8% interest, and income taxes (federal, state, and local) could be as high as 35%. When you do the math appended to this letter, the implied return on equity (net income after taxes divided by the value of the equity contributed by the buyer) works out to 27%.
By contrast, an unleveraged buyout (UBO?) at a 27% rate of return would imply a price /earnings multiple of (1/27% =) 3.7 times, about half of the LBO multiple of 7.
What is going on here?
Happy birthday, dear LBO’s: live long and prosper.
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