The first post was devoted to the definition of Leverage Buyout and possible montages. This second post proposes to address what distinguishes a good from a bad LBO, which recipe will make a success or a failure. In addition, through a simple case, we address the fragility of a company in a situation of LBO, a situation that can quickly switch to a difficult position.
Prerequisites for a Successful LBO
A successful LBO is often the result of careful thought upstream of the operation, a reflection that incorporates the importance of including factors that ultimately explain the success of the project.
- Stable, predictable cash flow businesses
It seems fairly clear that the visibility of future cash flows is a fundamental element of LBO setup. The latter is based on the implementation of a significant debt on the target company, it seems crucial that the latter can build this debt on strong, stable and predictable flows to repay it.
- Measured investment levels
The target must be able to control its investment volume over the medium term (7-10 years). This does not mean that the target must refrain from investing and simply renew its production device to the same. On the other hand, significant investment needs (organic or external growth) do not create the ideal conditions for an LBO (to consider that they were planned and budgeted upstream and identified, the situation would be less penalizing but it is not always the case …).
- Business in a mature phase
The target company will preferably be a mature company in its sector / products. This is a corollary of the previous condition. No way to target a new market / sector / product…
- Non-cyclical sector
This point seems obvious and yet … Number of LBOs was mounted on companies whose activity and / or sector were cyclical, causing serious difficulties on a near horizon. The company must rely on a relatively stable and solid medium term horizon allowing it to repay its financial commitments. Cyclical activity would not allow such a thing.
- Limited industrial risk
Industrial risk still exists, as doe’s entrepreneurial risk. It would be illusory to think of eliminating it. From then on, minimizing it or confining it seems reasonable. The business cannot rely on new and unproven technology. Once again, the company is not a start-up company and must develop its business based on known and proven technologies.
- Areas with high barriers to entry
The company preferentially has a favorable competitive situation (one of the leaders of its sector). Otherwise, it has a “franchise value “on one or more of its market niches. At the very least, it enjoys, like its sector, difficult access for its potential competitors and new entrants. The barriers to entry (right consequent, high regulation, minimum entry ticket,) Are sufficiently numerous and high that they discourage more than one. Doing an LBO on a company with none of these attributes can lead to serious setbacks
- Low substitution risk
The company also has a range of products and / or services that are very difficult to replicate and / or replace, making it difficult for anyone of its competitors to “trivialize” it. The strategy should be more a strategy of differentiation than a strategy based on the lowest marginal cost of production.
- Comfortable market share in a niche sector
The target company has a preponderant market share in its sector and, if possible, in these niche markets. Thus, this differentiating dominant position gives it the power to set prices and margins higher than any other player in the sector.
In the end, these few criteria mentioned here make it possible to draw more precisely the contours of the profile of the typical LBO candidate company. There will always be exceptions, but most of the time, setting up an LBO on a company that has none or few of these criteria will lead to failure.
After presenting these criteria of success, I propose to digitally illustrate the assembly of an LBO through a simple case that I will voluntarily vary to make him undergo some shocks to see how he reacts.
The basic Case Summary: main Hypotheses and Questions
Target company of an LBO, who’s annual EBITDA, is estimated at 220m €. No growth in EBITDA is anticipated over the modeling horizon (which is 5 years). The financial structure is € 800m, 15% of which is equity. The balance (i.e. € 650m) is the senior debt, the rate is 7% and the term is 10 years.
On this basis, and taking into account a multiple of exit envisaged to 5 years of 3 years of EBE, on the basis of an investment of 150m €, the investor realizes a return on own funds of 456%! Needless to say, it’s impressive. However, at the risk of tempering the ardor of some of you, this return is subject to a number of conditions, among which:
- The return is 100% made up of the exit, no intermediate flow being paid to the shareholder. What happens if the output multiple is upset?
- The accumulated cash is undistributed and is only at the end: again, what is the level of progress of this cash?
- The debt is in fine, i.e. paid at the end of the period, but what happens if the flows available then are not enough to repay it?
But given the return on equity expected, it would take a cataclysm for this to happen! Really? A simple sensitivity shows that, in reality, an average annual decline in EBITDA of 9.6% over the period would be sufficient to bring the IRR to zero and the debt in this circumstance would not be reimbursed, as equity capital was negative. 60m € at the end of the period. A hypothesis far from being a case study if a latent economic crisis as we know it comes to happen.
An alternative case to the one developed here is the one that integrates into the free cash flow the payment of the current principal of the LBO, posing a much smaller refinancing risk to the transaction than the previous case. It is still necessary that the flows released by the company allow it. However, the basic case presented here would allow it; intermediate flows (dividends) would then be collected by investors in addition to the exit value. The IRR’s own funds would be 33%.
A stress scenario of reducing the IRR to zero shows that only a drop in the EBITDA of 4.6% / year is sufficient, which means a probable situation. At this level, however, the debt is repaid but investors are content with their eyes to cry … An 8.8% decline in EBITDA annual average brings the value of equity to zero and jeopardizes the repayment of the outstanding debt at the end of the period (€ 325m).
Conducting a fine risk analysis and sensitizing various scenarios seems to be a prerequisite that is often ignored or botched. Behind the financial stakes, there are also issues of wealth creation and human issues that must constantly be kept in mind by the designers of these projects. In the end, they bear the responsibility.