Investment Banking: What Can Go Right and Wrong in a Leveraged Buyout - dummies

Investment Banking: What Can Go Right and Wrong in a Leveraged Buyout

By Matt Krantz, Robert R. Johnson

This example is very simplistic, but a couple of very significant developments can take place to make an LBO much more attractive to investment banks. An LBO is a moving target — the company that’s refinanced is changing, morphing, and hopefully growing. There are a few considerations investment bankers must consider when thinking about what can go right with an LBO, including the following:

  • EBITDA can improve. EBITDA is likely not to remain constant, but to grow over time. As EBITDA grows, assuming the multiple of EBITDA at which the firm sells for stays the same, the value of the firm will not remain constant, but will also grow.

  • Refinancing can make the deal more attractive. The firm may find that it’s actually able to refinance some of its debt at a lower interest rate.

  • Valuations on deals can be more positive. The multiple at which our firm may sell for can also expand. Given market conditions and the fact that our firm is less debt laden, that same cash flow stream may command a larger multiple than 7.5 times in five years.

    Suppose the cash flow stream commands a multiple of 10 times and we’re able to completely pay down our term loan of $900 million. Now, you have equity worth $2.1 billion. This represents an internal rate of return of 36.1 percent annually.

Circumstances can go against an LBO, too, and spell trouble for a deal. Some potential problem spots for LBOs include the following:

  • Returns end up being subpar. The LBO may not realize the rate of return that investment bankers project on their pro forma statements. Cash flows can, of course, fall short of projections, and you may not reach the levels of EBITDA forecast by overly optimistic analysts who want to see an LBO deal completed.

  • The economic climate may turn hostile. Economic conditions can change, and market interest rates may rise, making it more difficult, if not impossible, to refinance debt at lower rates.

  • Investors can sour on LBOs. What may prove to be most damaging is that investors in general may become more risk averse, shunning LBO deals, and the multiple of EBITDA at which the firm sells may decline.

    For instance, in our example, if the EBITDA multiple in five years is 5.5 instead of 7.5, the equity holders’ internal rate of return on the LBO will be 10.8 percent — less than half the rate of return it was expected to earn.