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What is a leveraged buyout?
A leveraged buyout is when an investor' typically a PE fund acquires a company using significant amount debt. Anywhere between 50 to 80% of the tag price of the company is funded with debt, allowing Private Equity or Buyout funds to invest very little equity of its own.
Given that cost of debt is typically lower and allows for a tax shield, PE companies make handsome returns when companies with the ability to generate high cash flows are able to service the debt over the 5 to 8 year holding period.
Returns are also generated from a higher tag price of the company at the time of sale which the PE fund is able to extract if it manages to sell at a higher exit multiple versus that of entry or increase the profitability of the investee company.
Let’s work with a case study
Assume a PE fund, (let’s call it City Ventures) just purchased a silicon chip company (Valley Inc.) for £100m. Given the strong cash flow of the business, banks were willing to lend City Ventures £80m to fund the deal. City poured in the rest of the £20m in the form of an equity investment.
Valley Inc. was producing £20m of free cash flow (FCF) at the time of the purchase, meaning that City Ventures purchased it at 5x it’s free cash flow.
After five years of holding the company and improving its profitability to £35m, City Ventures was able to sell the company at 8x FCF at £270. Let’s assume that the FCF generated by Valley Inc. allowed it to repay 80% of its debt in addition to servicing the interest expense. The total debt outstanding at exit was £16m (£80m *20%).
At exit City Ventures gets £254m (£270m exit value - £16m debt outstanding). Over a five-year period this equates to a 12.7x return or a mind boggling IRR of 66%.
The swanking return was generated by an 1. increase in profitability (£35m from £20m) 2. Higher exit multiple (8x) versus the entry multiple (5x) and 3) Paying back debt (£16m at exit versus £80m at entry)
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