Private Equity: Episode 13 – The LBO

The star operation of Private Equity, the LBO (Leverage Buy-Out), is a financial structure that allows for the acquisition of a company using leverage (borrowed funds).

In practice, in order to acquire a target company, investors pool together in a holding company and contribute capital. This holding company then takes out a loan, using the contributed capital to cover the acquisition price of the target company.

Once the transaction is finalized, the target company’s operations must generate enough cash flow to repay the interest and the holding company’s loan.

This structure relies on financial leverage, which is the ratio between the debt and the equity capital contributed.

The leverage effect is calculated as the difference between the return on equity and economic profitability.

In a company, the return on equity corresponds to the compensation for the investors who contributed the funds. It is determined by the formula Net Income / Equity.

Economic profitability measures the company’s ability to generate wealth, and it is calculated as: EBIT / Economic Assets.

Economic assets refer to the sum of fixed assets and working capital requirements (WCR).

Let’s take the example of a company with the following characteristics:

Economic assets = 10,000, financed with a 30/70 ratio, meaning:Equity = 3,000Debt = 7,000, with a 5% interest rateEBIT = 1,000Net Income = EBIT (1,000) – Interest (7,000 * 5% = 350) – Taxes (30% rate) = 455

We get:Return on Equity = 455 / 3,000 = 15.17%Economic Profitability = 1,000 / 10,000 = 10%

The leverage effect is therefore 5.17.

Without the loan, the return on equity would have been 1,000 – (30% taxes) / 10,000 = 6%.

Thus, we observe that using bank debt increases the return on equity.

We will soon see the impact of this leverage effect in an LBO operation.

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