This article is the third and final installment in our three part series on the leveraged buyout (“LBO”). Part I covers the first four steps of the standard deal process: sourcing, screening, the non-disclosure agreement, and due diligence. Part II covers the subsequent three steps: the indication of interest, letter of intent, and negotiation. The ten primary steps of the typical LBO are laid out in exhibit A.
This chapter will cover the sequence of actions that take you from the actual acquisition of the business, through the management period, and to its final sale.
Step VIII: Acquisition
This step launches the multi year period during which the buyer owns, manages, and helps grow the acquired business.
Every player involved in negotiating the deal (see part II for more details) — the buyer, seller, and depending on the transaction, the sellside advisor, sellside legal counsel, buyside advisor, buyside legal counsel, and buyside lenders — work together to execute the acquisition.
The financing structure is reviewed and vetted, the bookrunning bank syndicates the debt, lenders wire the funds, the new owner assumes official management of the business, and new directors — this often includes the fund partner that led the LBO and certain experts the fund believes to be value additive to the acquired business — take their seats on the Board of Directors.
Step IX: Management
This phase is, by far, both the longest and often most important part of the process. It begins when the buyer purchases the company, ends when it’s sold to another owner or goes public, and usually lasts three to ten years long.
This multi year period is when the buyer — now the owner — improves the business in ways that create value. We recently published an article that covers the three primary ways to create value during the ownership period. These levers are (a) earnings growth, (b) debt paydown, and (c) multiple expansion.
Earnings growth means that the business is becoming more profitable. This can be achieved by increasing the topline (i.e., organic growth), improving the bottomline (i.e., higher efficiency), or cultivating inorganic growth (e.g., acquisitions). Frequently it entails a combination of the three.
Debt paydown means that the business is increasing its equity-to-debt ratio. It accomplishes this by paying back borrowed funds and thereby reducing leverage. In other words, the company is not only generating excess cash, but using that cash to reimburse lenders that lent the capital to complete the buyout in the first place.
Multiple expansion means that the business is being sold for a higher earnings multiple than that at which it was bought (i.e., the new buyer is paying more for every dollar of earnings today than the original buyer did). The earnings multiple is usually expressed as a multiple of EBITDA (e.g., 5.5x EBITDA) and is covered in more detail in our article on why LBOs generate higher returns. Multiple expansion is typically a product of improved growth opportunities, increased company size, more efficient operations, favorable industry dynamics, or a bull (i.e., strong) market.
Before we move forward, one should note that these three types of value creation are not easy to execute. Growing the bottomline by 4% or paying down 3% of debt — perhaps — but to generate 20%+ of value every year requires a thoughtful process, a surefire blueprint, and rigorous execution.
As such, there are five general steps to methodically managing an LBO candidate.
Determining the potential. In this stage the owner defines a maximum value for the business. This process takes root throughout the first eight steps of the deal process, and is accomplished by identifying opportunities for improvement during due diligence, management meetings, external research, and internal analysis, and subsequently incorporating them into financial models.
The inputs to these models are the materials that the now-owner, formerly buyer, touches during the transaction process. As you might recall this includes public information, the company’s website, the teaser, the confidential information memorandum, historical and projected financials, contracts, legal records, management meetings, interviews with customers, industry analyses, etc.
Most buyers will create three models during the deal process: a downside case, a base case, and an upside case. The latter two reflect how the business would perform if management were to successfully implement some or all of the improvements. The former will maintain a set of conservative — often very conservative — estimates.
These financial models serve as a benchmark of future potential and illustrate what can be achieved over the management period.
Creating the game plan. The game plan is a comprehensive framework for how the business can reach its performance targets.
It outlines the strategic goals, tactical initiatives, necessary steps, which teams are involved, what changes must be made, and the execution timeline. The best buyers will sketch out the entire ownership period and will, according to Orit Gadiesh and Hugh Macarthur’s Lessons from Private Equity Any Company Can Use, include details on everything from day 1 activities to overarching strategy.
History has shown that one of the core advantages of financial sponsors over corporations is often their ability to identify the “few” activities that add the vast majority of the value, and focus obsessively on those activities. The owner’s aptitude in defining these high impact efforts minimizes the amount of time wasted on low-value-added efforts and enables it to exit in a short timeframe, while still maximizing returns.
Aligning the stakeholders. The primary goal here is to harness leadership talent and put it towards activities that facilitate the greatest gains in earnings, margins, or cash output.
The principal mechanism for alignment is a reward structure that puts management and owners on the same page. The arrangement should incentivize the company’s leaders to (a) embrace the game plan, (b) tackle value additive activities, and (c) shoulder otherwise burdensome tasks.
Moreover, the most effective reward structures will usually encourage leaders to be results-oriented, proactive, and strategically nimble. The primary goal is to foster an environment that is both metrics-driven and agile, such that management is motivated to both take on efforts that drive the company in the right direction, and adjust course when there are better tactics for achieving targets.
Laying the foundation. This is the process of sculpting the business to the game plan, and setting up necessary building blocks. It includes structural changes, matching employees to fundamental initiatives, and securing any necessary but currently unavailable resources.
During this stage, the company’s performance typically accelerates and the owner will begin to track certain operating indicators and iterate on the day-to-day game plan.
Optimizing financial efficiencies. This step focuses on improving the cash efficiency of a company. It entails the thoughtful application of buyout economics to the business. Specifically the owner will concentrate on two things:
- Improving operating income
- Improving net working capital
Operating income, usually defined as earnings before interest and taxes (“EBIT”), is a financial metric that gauges profitability. It is a primary focal point because it’s one of the core drivers of cash flow.
To improve income, owners undertake activities that optimize any financial line item above EBIT. This includes revenue, SG&A (selling, general, and administrative) costs, COGS (cost of goods sold), and other expenses.
For example, if we’re dealing with a business that requires raw inputs, the owner might run a search for additional suppliers that can provide materials at a lower cost than the company’s existing suppliers. It would then help the management team negotiate new contracts and phase these new partners into production. This type of activity would reduce COGS.
Improving net working capital (“NWC”) is the second component of financial discipline. NWC is essentially the amount of cash required to run the company: satisfy sales orders, pay operating expenses, and service short term debt obligations (i.e., those due within one year).
Net working capital = Current assets – Current liabilities
Current assets = Accounts receivable + Inventory + Prepaid expenses + Cash + Marketable securities
Current liabilities = Accounts payable + Accrued liabilities + Short term debt
Moreover, working capital is a use of cash. Higher working capital translates to lower liquidity. Lower working capital translates to higher liquidity.
This metric is of crucial importance because the higher the working capital, the higher the amount of cash tied up in running the day-to-day operations, and the less financially efficient the business. Capital providers are similarly focused on NWC because it gauges operating liquidity and is likewise one of the the core drivers of cash flow.
To optimize (meaning decrease) working capital, owners undertake activities that minimize current assets (“CA”) or maximize current liabilities (“CL”).
For example, an owner might implement a more proactive collections process and solicit customer payments closer to the point of sale. This would reduce accounts receivable, thereby reducing current assets, thereby reducing net working capital, and thereby increasing cash flow. Similarly, an owner might limit the company’s cash balance to the amount needed to meet day-to-day expenses, thereby lowering current assets and increasing cash flow. In addition, an owner might identify the optimal amount of inventory — that both allows for uninterrupted customer supply and reduces the amount of cash tied up in idle inventory. This action would reduce current assets, thereby reducing net working capital, and thereby increasing free cash flow.
On the other hand, an owner might choose to optimize net working capital by increasing current liabilities. For example, it might help the leadership team negotiate its supplier contracts from cash to credit — or more plausibly — from the current credit terms to more lenient credit terms (e.g., 30 day versus 45 day payment period). This type of activity would reduce the amount of cash tied up in working capital and increase the cash flow liquidity of the business.
The best financial sponsors are those that handle the management period extremely thoughtfully and meticulously. They are able to identify both the company’s strengths and its development areas, select the right (meaning most impactful) areas for improvement, come up with a game plan, execute on this plan, optimize the financial skeleton, and change course when the hypothesis warrants editing.
Step X: Exit
This step marks the end of the ownership period. On average, the exit occurs five years after the original purchase of the company. It can range from between three and ten years out.
The decision to exit is almost always a difficult balancing process. The (a) current sale prospects for the company have to be weighed against (b) untapped opportunities to create future value and (c) incentives to exit before the IRR flattens*.
Why is this? Because although good buyout candidates usually exhibit strong performance beyond just five or even ten years, the downward pressure on IRR increases in tandem with investment length, as returns are spread over more years.
For example, a good business can continue to generate additional cash-on-cash returns while simultaneously reducing IRR. As a result, incremental value creation opportunities usually need to be sizable in order to justify delaying an exit past a certain point.
Owners typically exit LBOs in one of four ways:
- Strategic buyout
- Secondary buyout (i.e., a sale to another financial sponsor)
- Management buyout
- Initial public offering
Exhibit E shows the comparative popularity of buyout exit strategies over roughly the last four decades.
Strategic buyouts occur when the company is sold to a corporation, commonly referred to as a “strategic buyer” or “strategic”.
This usually happens because the corporation sees value in vertical integration or the company’s product portfolio, customers, intellectual property, patents, brand, leadership, or synergy potential.
These exits also tend to offer the highest exit value because a strategic’s synergies and lower cost of capital (a result of lower leverage and a correspondingly higher credit rating) will be factored into the dollar sum that it’s willing to pay to purchase the business.
Secondary buyouts occur when the company is sold to another financial sponsor.
This usually requires a high degree of leverage and a favorable cost of capital, because the new buyer needs to be able to achieve high returns a second time around with the same business.
Consequently, secondary buyouts are often an outcome of the original buyer electing to exit within a certain timeframe in order to maintain a high IRR, and therefore occur predominantly with high performing businesses.
Additionally, these exits typically come with less of a premium than a strategic buyout, given the absence of cost or revenue synergies and the generally more restrictive sponsor debt terms.
Management buyouts (“MBOs”) occur when the existing management team purchases the business back from the current owner.
This type of exit occurs in a very specific scenario: when the financial sponsor wants to exit, members of the management team wish to make the transition from employees to owners, and there are no competitive bids from other buyers.
MBOs typically require a substantive amount of external financing and will usually entail a combination of equity and debt funding from the management team, third party capital providers, and sometimes the seller.
Initial public offerings (“IPOs”) occur when the owner decides to sell his stake in the public markets rather than to a private buyer (e.g., another sponsor or a strategic).
This involves going through the process of making the company a publicly traded entity but, depending on the markets, may result in a lower or higher value than a strategic or secondary buyout. Moreover, IPOs almost always offer only a partial exit to the owner, with the complete exit coming in subsequent secondary offerings.
*In certain highly successful leveraged buyouts, the decision to exit is weighed against the time at which IRR drops to a certain threshold rather than when it flattens. For example, if a company is generating 70% IRR over the first two years, an investor will most likely choose to retain the investment even if the IRR will almost certainly decline over the next several years. This illustrates the balancing act between achieving substantive cash-on-cash returns and maintaining a high IRR.
This concludes our three part series on the leveraged buyout deal process. Access part I here and part II here. Part I gives an overview of the first four steps of the process: how funds source deals, how they screen opportunities, the non-disclosure agreement, and how sellers run a solid due diligence process. Part II walks through the next three steps: the indication of interest, the letter of intent, and the negotiation process.