Leveraged Buyout Model

Description
In an LBO, the goal of the investing company or buyer is to make high returns on their equity investment, using debt to increase the potential returns. The acquiring firm determines if an investment is worth pursuing by calculating the expected internal rate of return (IRR), where the minimum is typically considered 30% and above.
The IRR rate may sometimes be as low as 20% for larger deals or when the economy is unfavorable. After the acquisition, the debt/equity ratio is usually greater than 1-2x since the debt constitutes 50-90% of the purchase price. The company’s cash flow is used to pay the outstanding debt.
Structure of an LBO Model:
In a leveraged buyout, the investors (private equity or LBO firms) form a new entity that they use to acquire the target company. After a buyout, the target becomes a subsidiary of the new company, or the two entities merge to form one company.
Capital Structure in an LBO Model:
Capital structure in a Leveraged Buyout (LBO) refers to the components of financing that are used in purchasing a target company. Although each LBO is structured differently, the capital structure is usually similar in most newly-purchased companies, with the largest percentage of LBO financing being debt. The typical capital structure is financing with the cheapest and less risky first, followed by other available options.
An LBO capital structure may include the following:
Bank Debt:
Bank debt is also referred to as senior debt, and it is the cheapest financing instrument used to acquire a target company in a leveraged buyout, accounting for 50%-80% of an LBO’s capital structure. It has a lower interest rate than other financing instruments, making it the most preferred by investors.
However, bank debts come with covenants and limitations that restrict a company from paying dividends to shareholders, raising additional bank debts, and acquiring other companies while the debt is active. Bank debts typically come with a payback time of 5 to 10 years. If the company liquidates before the debt is fully paid, bank debts get paid off first.
High Yield Debt/Subordinated Debt:
High-yield debt is typically unsecured debt and carries a high-interest rate that compensates the investors for risking their money. They have less restrictive limitations or covenants than there are in bank debts. In the event of a liquidation, high-yield debt is paid before equity holders, but after the bank debt. The debt can be raised in the public debt market or private institutional market. Its payback period is typically 8 to 10 years, with bullet repayment and early repayment options.
Mezzanine Debt:
Mezzanine debt is a small middle layer in the LBO capital structure that is a hybrid of debt and equity and is junior or subordinate to other debt financing options. It is often financed by hedge funds and private equity investors and comes with a higher interest rate than bank debt and high-yield debt.
Mezzanine debt takes the form of a high-yield debt with an option to purchase a stock at a specific price in the future as a way of boosting investor returns commensurate with the risk involved. It allows early repayment options and bullet payments just like high-yield debt. During a liquidation, mezzanine debt is paid after other debts have been settled, but before equity shareholders are paid.