LBO is performed when a firm is considering buying out another firm with the use of high levels of debt.
Let’s consider an example. Let’s say you have $10. However, you are able to borrow $90 more, so you can invest a total of $100. Now, let’s say you invest those $100 and you earn 10% interest on it (go up to $110). After you repay your debt of $90, you are left over with $20, which is a 100% return on your money you initially put in.
Leverage buyouts are very similar to this example. Usually a private equity firm targets a company, buys it, fixes it up, pays down the debt, and then sells it for large profits (at least that’s the plan).
In order to have a good buyout, the predictable cash flows are essential. This is why target companies are usually mature business that have proven themselves over time. The analysis part calculates what return is expected on the buyout.
How does it work?
LBO analysis is similar to a DCF analysis in relation to use of cash flows, terminal value, present value and discount rate. However, while in DCF analysis you are looking for the present value of the company (enterprise value), in LBO analysis you are actually looking for your internal rate of return (IRR). In addition to focusing on IRR, the LBO analysis considers whether there is enough projected cash flow to operate the company and also pay debt principal and interest payments.
The concept of a leverage buyout is very simple:
Buy a company –> Fix it up –> Sell it
And here are examples of why companies are doing it: