LEVERAGE BUYOUT ANALYSIS

LBOS ARE TYPICALLY USED BY “FINANCIAL SPONSORS” (PRIVATE

EQUITY FIRMS) WHO ARE LOOKING TO ACQUIRE COMPANIES
INEXPENSIVELY IN THE HOPES THAT THEY CAN BE SOLD AT A
PROFIT IN SEVERAL YEARS. IN ORDER TO MAXIMIZE RETURNS
FROM THESE INVESTMENTS, LBO FIRMS GENERALLY TRY TO USE AS
MUCH BORROWED CAPITAL (DEBT FINANCING) AS POSSIBLE TO
FUND THE ACQUISITION OF THE COMPANY, THEREBY MINIMIZING
THE AMOUNT OF EQUITY CAPITAL THAT THE SPONSOR ITSELF MUST
INVEST (EQUITY FINANCING). ASSUMING THAT THE INVESTMENT
MAKES A PROFIT, THIS DEBT LEVERAGE MAXIMIZES THE RETURN
ACHIEVED FOR THE SPONSORS’ INVESTORS.

Three Possible Approaches to take

in running an LBO analyis for a
target company:

1ST APPROACH
1. Assume a minimum required return
for the financial sponsor plus an
appropriate debt/equity ratio, and
from this impute a company value.

2ND APPROACH
2. Assume a minimum required return
for the financial sponsor plus an
appropriate company value, and from
this impute the required debt/equity
ratio.

3RD APPROACH
3. Assume an appropriate debt/equity
ratio and company value, and from this
compute the investment’s expected
return.

Us ually the first analysis is performed by investment bankers. If the value of the
company is unknown (as is usually the case), then the goal of the LBO exercise is to
determine that value by assuming an expected return for a private equity investor
(typically 20-30%) and a feasible capital structure, and from that, determining how
much the company could be sold for (and thereby still allow the financial sponsor to
achieve that required return). If the expected sale price/value of the company is
known (for example, if a bid on the company has been proposed), then the primary
goal of performing an LBO analysis is to determine the best possible returns scenario
given that value. (Bankers will often use LBO analysis to determine whether a higher
valuation from private equity investors is possible, again using the first analysis.)

Sources:
https://www.streetofwalls.com/finance-training-
courses/investment-banking-technical-training/valuation-
techniques-overview/