Valuation for Mergers, Buyouts, and Restructuring, Second Edition

Chapter 13

Leveraged Buyouts

13.1 THE RATIONALE FOR LBOs

This chapter deals with the financial structure and valuation of leveraged buyouts (LBOs) and other leveraged recapitalizations. In an LBO transaction, a group of investors finance the acquisition of a corporation or division mainly by borrowing against the target's future cash flows. The buyout is organized and effected by the promoters, which include a sponsor and, often, existing management as well. When the latter is an important part of the promotion group, the LBO is called a management buyout (MBO). The sponsor is usually an LBO equity fund or the merchant-banking arm of a financial institution. It provides the core equity and effectively controls the acquisition.

LBOs contribute to the better allocation of resources in the economy by improving the performance of the acquired firms.¹ The expected gains lead promoters to pay a premium over the public value of the target, to the public shareholders' benefit. Empirical research shows stock prices tend to go up at the time of buyout announcements. One study found that prices went up by about 30% from 40 days prior to the day of the buyout proposal, after adjustment for general market movements, and by 22% in the 2 days surrounding the announcement of the initial proposal.²

LBOs are financed mainly with secured bank debt and unsecured subordinated debt. LBOs worth more than about $400 million may be able to raise subordinated debt in the public high-yield market. Small ...