Buyouts — a clear explainer
Definition
– Buyout: a transaction in which an investor or group purchases a controlling stake in a company (normally more than 50%) so that control shifts to the buyer. In practice the term is often used interchangeably with “acquisition.”
– Management buyout (MBO): when a company’s existing managers purchase the controlling interest.
– Leveraged buyout (LBO): when the buyer funds a large portion of the purchase with borrowed money, typically using the target company’s assets and future cash flows as collateral.
Why buyouts happen (short summary)
– Owners want an exit (retirement, refocus on core business, or divestment of a non-core unit).
– Management wants control or an ownership stake.
– Private equity firms see a chance to buy an underperforming or undervalued company, improve operations, and later sell or take it public.
– Strategic buyers want to consolidate market position or acquire specific assets or technology.
How a buyout typically works — stepwise
1. Target selection: buyer identifies a company to acquire (often one with steady cash flows or undervalued assets).
2. Valuation and deal structure: buyer agrees a total purchase price and splits funding between equity (cash from the buyer/fund) and debt (bank loans, bonds, mezzanine).
3. Due diligence: financial, legal, tax, operational checks to verify risks and hidden liabilities.
4. Financing: debt commitments are arranged; equity is committed by the buyer or investors.
5. Closing and control transfer: buyer acquires the controlling stake; management and board can change.
6. Ownership period: buyer executes a plan (cost cuts, asset sales, growth initiatives) to increase value.
7. Exit: the owner sells the business, takes it public, or otherwise disposes of the investment.
Key features and risks
– Control threshold: buyouts give the buyer a majority stake and the power to make strategic and operational changes.
– Leverage: LBOs magnify returns if the company’s cash flows and value improve, but they also increase bankruptcy and refinancing risk if cash flow falters.
– Collateral: lenders often use the target’s assets and future cash flow projections as loan security.
– Typical buyers: private equity funds, institutional investors, wealthy individuals, or the company’s own managers.
Checklist for evaluating a buyout target
– Control and governance: Will acquiring >50% give the buyer needed authority? Are there shareholder agreements or “shotgun” clauses to consider?
– Cash flow sustainability: Are
cash flows sustainable: Are projected operating cash flows (cash from operations minus capital expenditures = free cash flow) large and stable enough to service interest, meet principal amortization, and fund working capital? Run sensitivity/stress tests (e.g., -10%, -25% revenue scenarios). Useful ratios: interest coverage = EBIT / interest expense; debt/EBITDA; free cash flow to debt. Typical thresholds vary by industry but many lenders target interest coverage > 2.5–3x and debt/EBITDA covenant minimum throughout life (or flag default).
– Debt schedule feeds consistently into balance sheet and cash flow.
– Check that small changes in inputs produce reasonable changes in returns.
Worked numeric example (simple, illustrative)
Assumptions (Year 0 = purchase date)
– Entry EBITDA = $25.0m.
– Purchase EV = 8.0 × EBITDA = $200.0m.
– Financing: Debt = $120.0m, Equity = $80.0m (so Net debt = $120m if cash = 0).
– Forecast horizon = 5 years.
– EBITDA growth: CAGR ≈ 10% → Year5 EBITDA = 25 × (1.10)^5 ≈ $