How do Leveraged Buyouts Generate Value?

How do Leveraged Buyouts Generate Value?

LBOs refer to a commonly used financing strategy often employed by private equity firms to acquire companies using substantial debt to pay for the acquisition cost. Such deals often result in an increased concentration of ownership, and their leverage magnifies financial returns to equity. In a typical LBO transaction, the firm’s tangible assets to be acquired serve as collateral for the loans. The most liquid assets (receivables and inventory) usually are employed as collateral for securing bank financing. The firm’s fixed assets customarily are used to obtain a portion of long-term senior financing. Subordinated debt, either unrated or low-rated debt, is employed to raise the purchase price balance. When a public business agrees to an LBO, it is going private because its equity got acquired by a small group of investors and is no longer publicly traded. In this post, i provide my insights on how do Leveraged buyouts generate value.

How do Leveraged Buyouts Generate Value?


In multiple instances, i have seen private equity firms launching the takeover utilizing the target’s excess cash balances or sell certain target assets and employing the proceeds to buy out current shareholders. If the target’s outstanding debt remains unchanged, the target firm’s debt-to-equity ratio will increase due to the decline in the firm’s equity (i.e., assets decrease relative to liabilities, contracting the firm’s equity). Corporate debt employed to fund such deals is issued in the target firm’s name since it is more likely to be sanctioned in its country. To shield lenders, “choice of law” contract provisions specify that violations of debt covenants are subject to the corporate and bankruptcy laws with strong creditor protections.

Leveraged Buyouts vs. IPO vs. Strategic Sale

The decision to go for an IPOs or LBOs depends massively on debt and equity market conditions. IPOs are favorable when the stock market is surging; LBOs are more prevalent when debt is readily obtainable and inexpensive, making deals more attractive to private equity firms. Selling to a strategic acquirer usually results in the most suitable price because the buyer may create significant synergies by merging it with its current business. However, selling to a private equity firm can present an even more attractive price when the target is poorly operating and has fewer investment opportunities. Private equity firms usually have more potent expertise in managing underperforming firms and access to more affordable capital.

Not Overpaying

Overpaying for LBOs can be destructive. Failure to meet debt service commitments promptly demands that the LBO firm renegotiate the loan agreements’ lenders’ terms. If the parties to the transaction cannot strike a settlement, they may be compelled to file for bankruptcy, often wiping out the initial investors. Highly leveraged firms are further subject to aggressive tactics from competitors, recognizing that taking on large amounts of debt increases its breakeven point. If the sum borrowed is made even more excessive due to having paid more than the target firm’s business value, competitors may increase market share by lowering product prices. The LBO firm cannot match such price cuts because of the required interest and principal repayments.

How do Leveraged Buyouts create value?

Several factors connect to generate value in an LBO. Public firms create value through LBOs by reducing underperformance linked to agency conflicts between management and shareholders; for private firms, LBOs improve capital access. Let us take a case study of Blackstone’s investment in the Hilton hotel chain in 2007 for $26 billion. To buy Hilton, Blackstone offered $5.5 billion and borrowed the rest. Over the next few years, Blackstone improved Hilton’s operating performance through disciplined management and used the resulting profits to decrease debt.

Concerns about Hilton’s capacity to repay its debt caused the market value of its debt to fall. Blackstone restructured Hilton’s outstanding debt purchasing back some of the debt from lenders at discounts of as much as 65% of face value and then refinance the outstanding debt at low-interest record rates by investing another $1 billion into the business, taking its total equity stake in Hilton to $6.5 billion or 76% of total equity. In the IPO, Hilton raised $2.4 billion, most of which used to pay off additional debt, bringing the firm’s outstanding debt to $12.5 billion. Shortly following the IPO, Hilton shares traded at $21.50 per share, delivering Hilton a market capitalization of $21.2 billion and Blackstone’s ownership stake a value of $16.1 billion. Blackstone had a $9.6-billion profit ($16.1 billion* 0.76 = $6.5 billion).

Overcoming Agency conflicts

While access to liquid public capital markets enables a firm to lower its WACC, participating in public markets may create disagreements between the board and management on the one hand and shareholders on the other, so-called agency problems.

Private equity investors try to deal with agency conflicts through enhanced governance by electing small boards with five to seven members. The private equity firm usually takes three of the board seats, with one or two more going to management and the rest to outsiders not affiliated with the buyout firm. The hypothesis is that the private equity investors’ specific industry knowledge can support grow the business. The small size of the board makes it plausible to be more agile in decision-making.

Providing Access to Capital for Private Firms

For private firms, agency conflicts are not a concern due to the concentration of ownership and control. Private firms usually engage in LBOs to get access to capital and allow founders to partially or take cash out of business. Given access to private equity investors’ additional money, LBOs of private firms launched by private equity investor groups regularly enable such firms to improve asset and revenue growth, employment, and capital expenditures. Private firms having undergone LBOs furthermore tend to be more profitable and endure faster growth than their peers due to the PE firm’s professional management methods, to track performance, and readiness to take the required actions to enhance firm performance because of the discipline imposed by the need to repay principal and interest payments.

Creating a Tax shield

LBOs often do not pay taxes for most of the holding period due to the tax-deductibility of interest and the added depreciation rising from net acquired assets’ write-up to fair market value. Profits are shielded from taxes until a principal portion of the outstanding debt gets repaid and the assets depreciated. Investors employ the target firm’s cumulative free cash flow to improve firm value by paying debt and developing operating performance.

Improvement in Operating Margin

PE firms reinvest cumulative free cash flow, as they tend to concentrate more on revenue growth because they have substantial experience and proprietary industry knowledge rather than on cost reduction. They achieve revenue gains by combining new product/service introduction, enhanced marketing efforts, and targeted acquisitions. The margin increase expands operating cash flow, which boosts the firm’s equity value if the risk level is constant.

Timing the exit

LBOs may profit from growing industry multiples while the firm is private. The rise in firm value depends on the valuation multiples like revenues, cash flow, or EBITDA. LBO investors generate value by timing the firm’s exit to coincide with the decline of the firm’s leverage to the industry leverage and when the industry in which the business competes is most attractive to investors.

I have built a financial model to demonstrate how LBOs create value by “paying down” debt, in part using the cash generated by tax savings, by improving the firm’s operating margins, and by increasing the multiple applied to the firm’s EBITDA in the year in which the firm exit. Each case assumes that the sponsor group pays $500 million for the target firm and finances the transaction by borrowing $400 million and contributing $100 million in equity. The sponsor group is assumed to exit the LBO at the end of 7 years. In Case 1, all cumulative free cash flow gets used to reduce outstanding debt. Case 2 considers the identical exit multiple as Case 1, but that cumulative free cash flow is higher due to margin improvement and reduces interest and principal repayments due to debt reduction. Case 3 considers the identical cumulative free cash flow for debt repayment and EBITDA in Case 2 but a more significant exit multiple.

How do Leveraged Buyouts Generate Value?

Final Thoughts

At the right price, LBO’s are not human-made disasters as commonly perceived by experts. In my view, LBO’s have added the target firm’s value concerning strategy development, operational, financial, and human resource management, marketing, and sales because of the Private Equity firm’s more focused, less bureaucratic approach. 


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