INVESTMENT BANKING TECHNICALS - LBO MODELLING EXAM QUESTIONS AND ANSWERS WITH COMPLETE SOLUTIONS VERIFIED LATEST UPDATE
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Module
LBO
Institution
LBO
INVESTMENT BANKING TECHNICALS - LBO MODELLING EXAM QUESTIONS AND ANSWERS WITH COMPLETE SOLUTIONS VERIFIED LATEST UPDATE
What is a Leveraged Buyout? (Technical Explanation)
In a leveraged buyout, a private equity firm acquires a company, financing the transaction with a mixture of debt and equit...
What is a Leveraged Buyout? (Technical Explanation)
In a leveraged buyout, a private equity firm acquires a company, financing the
transaction with a mixture of debt and equity. Typically, the PE firm will want to leverage
the deal as much as possible, and will pay the remainder of the purchase price with
equity, that typically being their own cash.
Once the sponsors gain majority control of the company, they get to work on
streamlining the business - which usually means operational improvements,
restructuring, and asset sales intending to make the company more efficient at
generating cash flow so that the large debt burden can be quickly paid down.
The investment horizon for sponsors is 5-7 years, at which point the firm hopes to exit
by either: Selling the company to another private equity firm or strategic acquirer Taking
the company public via an initial public offering (IPO). Assuming they've managed to
pay off their debt, the PE firm realises a large return (as sponsor equity has grown).
What is the intuition underlying the usage of debt in an LBO?
, The typical transaction structure in an LBO is financed using a high percentage of
borrowed funds, with a relatively small equity contribution from the financial sponsor. As
the debt principal is paid down throughout the holding period, the sponsor will realize
greater returns at exit. Therefore, private equity firms attempt to maximize the amount of
leverage while keeping the debt level manageable to avoid bankruptcy risk.
I.e. The primary intuition behind using debt in an LBO is to amplify the potential returns
on equity. By financing the majority of the acquisition with debt, the private equity firm
(or buyer) reduces the amount of equity capital it needs to invest. This can significantly
boost the return on equity if the investment performs well.
Moreover, if a sponsor can acquire a lot of debt, they can afford transactions without
having to use their own cash.
What is a Leveraged Buyout (Real-Life Example)?
One metaphor to explain an LBO is "house flipping," using mostly borrowed money.
Imagine you found a house on the market selling for a low price, in which you see an
opportunity to sell it later for a higher price at a profit.
You end up purchasing the house, but much of the purchase price was financed by a
mortgage lender, with a small down payment that came out of your pocket.
In return for the lender financing the home, you have a contractual obligation to repay
the full loan amount plus interest.
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