It is the acquirement of another firm using a substantial quantity of borrowed capital (bonds or loans) to meet the cost of acquisition.
Usually, the assets of the firm that is acquired are utilized as collateral for the loans along with the assets of the acquiring firm.
Leveraged buyouts enable firms to make mega acquisitions without the requirement to invest too much capital. As far as an LBO is concerned, there is normally a ratio of 90% debt to 10% equity.
Due to the great debt/equity ratio, the bonds normally are not categorized as an investment grade and are known as junk bonds.
In the past, leveraged buyouts have resulted in the bankruptcy of the acquired firms since the leverage ratio was almost 100% and the interest payments were huge, and hence the firm’s operating cash flows were not able to service the obligation.
Applications of The LBO Assessment
- Define the maximum buying price for an enterprise that can be paid on the basis of some leverage (debt) and equity return specifications.
- Create an insight of the leverage and equity features of a leveraged transaction at a distinct price.
- Estimate the minimum assessment for an organization because in the nonexistence of key buyers, an LBO firm must be a willing buyer at a price that provides an estimated equity return that meets the organization’s hurdle rate.
Steps in the LBO assessment
- Create operating expectations and predictions for the independent firm to determine EBITDA and cash flow required for debt servicing through the investment horizon (normally 3 to 7 years).
- Identify critical leverage levels and capital structure that results in an accurate financial report and credit statistics.
- Measure the equity returns (IRRs) to the monetary benefactor and inform the outcomes to a wide array of leverage.
- In LBO transactions, financial purchasers look to create exceptional returns on the equity investments and utilize financial leverage (debt) to enhance the probable earnings.
- Financial purchasers assess investment prospects by evaluating the projected internal rates of return (IRRs), which assess returns on invested equity.
Leveraged buyouts enable mega-firms to acquire smaller firms with insignificant personal capital. The acquired firm also improves its efficiency through corporate restructuring. Traditionally, leveraged buyout plans have made an impact on the corporate sector.